Decentralization Chapter 10

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 2 Decentralization in Organizations Benefits of Decentralization Top management freed to concentrate on strategy. Top management freed to concentrate on strategy. Lower-level managers gain experience in decision-making. Lower-level managers gain experience in decision-making. Decision-making authority leads to job satisfaction. Decision-making authority leads to job satisfaction. Lower-level decision often based on better information. Lower-level decision often based on better information. Improves ability to evaluate managers. Improves ability to evaluate managers.

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 3 Decentralization in Organizations Disadvantages of Decentralization Lower-level managers may make decisions without seeing the “big picture.” Lower-level managers may make decisions without seeing the “big picture.” May be a lack of coordination among autonomous managers. May be a lack of coordination among autonomous managers. Lower-level manager’s objectives may not be those of the organization. Lower-level manager’s objectives may not be those of the organization. May be difficult to spread innovative ideas in the organization. May be difficult to spread innovative ideas in the organization.

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 4 Decentralization and Segment Reporting segment A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data. A segment can be... Quick Mart An Individual Store A Sales Territory A Service Center

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 5 Cost, Profit, and Investments Centers Cost Center A segment whose manager has control over costs, but not over revenues or investment funds. Cost

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 6 Cost, Profit, and Investments Centers Profit Center A segment whose manager has control over both costs and revenues, but no control over investment funds. Revenues Sales Interest Other Costs Mfg. costs Commissions Salaries Other

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 7 Cost, Profit, and Investments Centers Investment Center A segment whose manager has control over costs, revenues, and investments in operating assets. Corporate Headquarters

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 8 Cost, Profit, and Investments Centers Responsibility Center Responsibility Center Cost Center Cost Center Profit Center Profit Center Investment Center Investment Center Cost, profit, and investment centers are all known as responsibility centers.

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 9 Return on Investment (ROI) Formula ROI = Net operating income Average operating assets Cash, accounts receivable, inventory, plant and equipment, and other productive assets. Cash, accounts receivable, inventory, plant and equipment, and other productive assets. Income before interest and taxes (EBIT) Income before interest and taxes (EBIT)

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 10 Return on Investment (ROI) Formula Regal Company reports the following: Net operating income $ 30,000 Net operating income $ 30,000 Average operating assets $ 200,000 Average operating assets $ 200,000 Sales $ 500,000 Sales $ 500,000 $30,000 $200,000 15% = 15% ROI =

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 11 Return on Investment (ROI) Formula ROI = Net operating income Average operating assets Margin = Net operating income Sales Turnover = Sales Average operating assets ROI = Margin  Turnover

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 12 Return on Investment (ROI) Formula Net operating income Sales Average operating assets × ROI = $30,000 $500,000 × $200,000 ROI = 6%  2.5 = 15% ROI = Margin  Turnover

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 13 Controlling the Rate of Return Three ways to improve ROI...  Increase Sales  Reduce Expenses  Reduce Assets

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 14 Controlling the Rate of Return Regal’s manager was able to increase sales to $600,000 which increased net operating income to $42,000. There was no change in the average operating assets of the segment. Let’s calculate the new ROI.

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 15 Return on Investment (ROI) Formula Net operating income Sales Average operating assets × ROI = $42,000 $600,000 × $200,000 ROI = 7%  3.0 = 21% ROI = ROI increased from 15% to 21% ROI = Margin  Turnover

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 16 Criticisms of ROI In the absence of the balanced scorecard, management may not know how to increase ROI. Managers often inherit many committed costs over which they have no control. Managers evaluated on ROI may reject profitable investment opportunities.

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 17 Criticisms of ROI As division manager at Winston, Inc., your compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus. The company requires an ROI of 15% on all new investments -- your division has been producing an ROI of 30%. You have an opportunity to invest in a new project that will produce an ROI of 25%. As division manager would you invest in this project?

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 18 Criticisms of ROI As division manager, I wouldn’t invest in that project because it would lower my pay!

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 19 Criticisms of ROI Gee... I thought we were supposed to do what was best for the company!

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 20 Residual Income - Another Measure of Performance Net operating income above some minimum return on operating assets

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 21 Residual Income A division of Zepher, Inc. has average operating assets of $100,000 and is required to earn a return of 20% on these assets. In the current period the division earns $30,000. Let’s calculate residual income.

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 22 Residual Income

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 23 Quick Check Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI? a. 25% b. 5% c. 15% d. 20%

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 24 Quick Check Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI? a. 25% b. 5% c. 15% d. 20% ROI = NOI/Average operating assets = $60,000/$300,000 = 20%

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 25 Quick Check Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 26 Quick Check Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No ROI = $78,000/$400,000 = 19.5% This lowers the division’s ROI from 20.0% down to 19.5%.

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 27 Quick Check The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 28 Quick Check The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No ROI = $18,000/$100,000 = 18% The return on the investment exceeds the minimum required rate of return.

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 29 Quick Check Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income? a. $240,000 b. $ 45,000 c. $ 15,000 d. $ 51,000

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 30 Quick Check Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income? a. $240,000 b. $ 45,000 c. $ 15,000 d. $ 51,000 Net operating income$60,000 Required return (15% of $300,000)$45,000 Residual income$15,000

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 31 Quick Check If the manager of the Redmond Awnings division is evaluated based on residual, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 32 Quick Check If the manager of the Redmond Awnings division is evaluated based on residual, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No Net operating income$78,000 Required return (15% of $400,000)$60,000 Residual income$18,000 This is an increase of $3,000 in the residual income.

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 33 Motivation and Residual Income Residual income encourages managers to make profitable investments that would be rejected by managers using ROI.

© The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 34 Let’s get to work on my ROI... End of Chapter 12